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How to analyze risk

A tightrope walker ready to traverse a cable over Niagara Falls takes both a risk and a chance. The risk can be increased or decreased depending on the walker's skills, amount of practice, safety measures, and quality of equipment. You or I would be taking more risk than an experienced performer.

The chance, however, is uncontrollable. A sudden attack by birds or bolt of lightning could strike anyone, experienced or not. Everyone would be taking the same chance.

Once you've decided to take the chance, one rule of investing is to measure and control the risk. Before you and your investment adviser can plan your investment objectives, you must learn how to recognize the risks that exist in various types of financial instruments, and decide on your own personal apetite for such risk.

Risk is a measure of the possibility that you will not receive your expected return on an investment. Generally, risk and reward move in the same direction over time. Higher returns over a long time period are often the reward that go with higher risk investments; but not always. Some investments never make money and all too often lose the original capital as well. A smart investor always measures the risk.

There are several types of risk that one must be aware of when deciding where to invest money. One such risk is purchasing power risk. This is the possibility that the return on your investment will not keep up with inflation and as such your money will not buy as much in the future as it will today. Any investment that generates low returns relative to a rising cost of living, or where the original invested capital is not expected to rise in value over time, suffers from purchasing power risk. Usually fixed rate investments such as GICs or Bonds are most closely aligned with purchasing power risk. When you buy one of these products the yield is fixed until maturity so that no matter how high the cost of living gets over the term of the investment, you investment return won't be adjusted. Similarly the original invested capital loses buying power over time during inflationary periods because although its value will be the same at maturity as when the investment was made, those dollars won't buy as much as when the investment was made. Variable return investments such as stocks or mutual funds or even real estate are better equipped to deal with inflation. The companies whose stock you or a mutual fund own can usually adjust their product pricing to deal with inflation so that their income and your subsequent dividend payments can keep pace with higher costs. The invested capital as well generally increases over time as the stocks gain in value. Real estate prices also normally rise with inflation. Certainly stocks and real estate can lose value but this is a different type of risk which is covered later..

A second kind of risk is financial risk. This is the possibility you will not be able to recover your invested capital due to the insolvency of the company whose stock or bonds you own. Financial risk therefore is a measure of the quality of the investment you select compared to other similar investments. Stocks as an asset class generally have a higher financial risk than bonds because companies in financial difficulty will pay bond interest before stock dividends. However within a given asset class there are different levels of financial risk as well. For example, Government bonds generally have less financial risk than corporate bonds. Futhermore, each of these categories can be graded as well according to their quality. Some corporate bonds with a rating of B or lower are called junk bonds, and are much more speculative in nature than a bond with a double or triple A rating. Real estate may be subject to financial risk if tenants suddenly leave, damage the property, or are unable to pay their rent. Investments with relatively low financial risk include Canada Savings Bonds, Government bonds, and bank and trust company deposits. Precious metals and collectibles are usually unaffected by financial risk because you actually hold a tangible asset.

A third form of risk , interest rate risk, results from uncertainty in the direction of future interest rates and the impact that increasing or decreasing rates will have on an investment. All interest-bearing investments carry this risk. If for example you purchase a $20,000.00 bond with a yield of 5% for a 10-year term and the following year interest rates for similar quality bonds with comparable terms have risen to 7%, you will have lost the opportunity to obtain the higher rate on your investment. In addition if you try to sell your bond, a prospective buyer will not give you $20,000 for it but instead will offer you a reduced price so that they obtain a 7% yield on their money; otherwise they wouldn't buy it. Interest rate risk increases with the length of the investment. In the above example it the original term of the bond was 20 years instead of 10 years, the prospective buyer would have to reduce his offer price even further to generate a 7% yield over the additional 10 years. The longer the term of the bond the greater its value will fall in periods of rising interest rates and conversely the greater its value will rise in periods of falling interest rates.

Market risk is the uncertainty of the future market value of your investment due to investor demand. The more demand there is for stocks in general, the more the increasing value of your investment is less a result of the underlying fundamentals of the company is which you invested and the more it is a result of prospective buyers bidding up the price. Investor purchase mania can push stock prices to such high levels that a significant crash in prices is inevitable once the buying exuberance ends. Technology stocks are a good example, as they tend to go in and out of favour quickly.

Political, exchange rate and social risks arise from instability of governments, nationalization of industries, currency speculation, and shifts in consumption and production patterns. With social risks, for example, if certain foods are found to be unhealthy, those industries may experience sudden drops in sales. Or, if changes in technology render a product obsolete, production patterns will change. That explains the low price of Amalgamated Buggy Whips.

One last form of risk is liquidity risk or the danger that you will be unable to sell your investment when you choose because either there isn't a market for this type of investment or there are insufficient buyers. Good liquidity usually exists for Government and most corporate bonds, Canada Savings Bonds, bank deposits, actively-traded common and preferred shares, and gold and silver bullion.

How do you sort through all these risks? It depends on your circumstances. If you are young with time to recoup losses and are interested in growth over the long term, you won't worry as much about market risk. If however you are about to retire concerns about preserving your capital may force you to avoid market risk but accept more interest-rate and purchasing power risk. If you are planning changes in your lifestyle, you may want to minimize your liquidity risk to enable to sell investments quickly if you have to.

One very useful tool for managing risk is diversification: holding different kinds of investments in varying amounts to spread out the different types of risk.

With proper investment planning, what looks like a tightrope walk over Niagara Falls can feel more like a stroll around the block.

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© , Fiscal Agents Money Management Newsletter
25 Lakeshore Road, Oakville, On L6K 1C6.
(905) 844-7700


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